Moody’s today (Tuesday) cut three Cypriot banks, including covered bond issuers Bank of Cyprus and Marfin Popular Bank, following a downgrade of the sovereign on Friday.

The rating agency cut Bank of Cyprus from Ba1 to Ba2 and Marfin Popular Bank by three notches from Ba2 to B2. Both issuers were placed on review for further downgrade. Moody’s also downgraded Hellenic Bank, from Ba1 to Ba2.

Bank of Cyprus’s Greek mortgage backed programme and Marfin’s Greek and Cypriot mortgage backed programmes were downgraded in May from Baa1 to Baa3 following a downgrade of Cyprus and the respective issuers.

Cyprus’s rating was downgraded from Baa1 to Baa3 and placed on review for further possible downgrade on Friday. Moody’s cut the sovereign because of – among other reasons – a high likelihood that the Cypriot banking system will require state support in 2012, the Cypriot government’s loss of international market access, and a weak institutional capacity in Cyprus to approve and implement necessary structural changes.

Moody’s said the action on the banks was driven primarily by the reduced ability of the country to support its large banking system, which has an asset base of domestically owned assets equivalent to six times the country’s gross domestic product.

“Moody’s reassessment of the sovereign capacity to support the banking system reflects a weakening in the strength of the country’s balance sheet,” it said, “as indicated by the two notch downgrade of Cyprus’s government bond ratings.”

Marfin was seen by Moody’s as being particularly affected by the rating action on the sovereign.

Moody’s said the multi notch downgrade of Marfin reflected a weakening of the bank’s standalone credit strength in addition to the reduction of support provided by the government.

Marfin has higher exposure to Greek government bonds compared with its peers, according to Moody’s, with about 91% of tier one capital, and the bank was identified as particularly vulnerable to losses under a revised deal on greater private sector involvement (PSI) announced on 27 October. The rating agency said this would imply a haircut of 50%.

Moody’s said that after accounting for this 50% haircut on Greek government bond holdings, losses already taken, and tax benefits, it estimated that Marfin would require capital of more than Eu1bn to meet the central bank’s minimum core tier one capital requirements of 8% and conform with the European Banking Authority’s 9% minimum core tier one.

“While the bank is exploring various options to address this gap, given the current difficult market conditions,” said the rating agency, “the task of raising such a substantial amount of capital (equivalent to around 5% of Cypriot GDP) by June 2012 significantly increases the likelihood that the bank will require a large capital injection from the government.”

The Bank of Cyprus could cover the capital shortfall triggered by the proposed Greek government bond impairments without any external assistance, noted Moody’s.

Moody’s review of the banks will focus on their funding and liquidity profiles, further deterioration in the banks’ non-performing assets, and pressure on the banks’ profitability.